Smart investing

Money Market Misconceptions

According to valuation-based asset manager RE:CM, investors need to be well informed about the risks associated with money market investments.

The primary objectives of a money market fund are capital protection and provision of liquidity. Yet during the global credit crisis, it became evident that even money market funds can suffer capital losses and liquidity constraints.

Prior to the crisis, traditional money market securities were offering low yields and low risk premiums compared to historic levels. This led to many managers searching for alternative sources of higher yield such as asset-backed commercial paper (ABCP) with AAA credit ratings at the time.

As it turned out, around 15% of the ABCP market was backed by subprime debt and the widening of ABCP spreads after the subprime crisis lead to The Reserve Primary Fund, the oldest money market fund in the US, “breaking the buck” or falling below a $1 NAV.

Many other funds experienced significant volatility as the credit crisis progressed, and several managers had to provide capital injections or purchase illiquid assets from their portfolios to prevent their own money market portfolios falling below $1.

While most investors perceive money market investments to be very low risk or even risk-free, this is by no means the case. In order to target higher yields, portfolio managers take on additional risk. This additional risk is not always justified by the reward proposition.

As such, investors in money market funds should check that their fund manager has implemented appropriate strategies to mitigate these risks and is following a consistent and disciplined approach when investing in low-risk income opportunities.

There are a number of investment risks associated with money market funds including reinvestment risk, counterparty risk, instrument risk, and liquidity risk.

Reinvestment risk

Reinvestment risk is the risk of investing maturing funds at a lower interest rate and getting a lower yield than on the maturing investment.

If inflation is rising, the MPC will typically raise short-term rates and vice versa. Although inflation has been rising in the past year, the MPC has kept interest rates unchanged.

This has affected interest rate expectations, resulting in uncertainty and volatility in short-term interest rates. The task of managing reinvestment risk can be cumbersome if short-term interest rates are highly volatile.

Counterparty risk

Counterparty risk is the risk that the counterparty or issuer of the debt will fail to fulfill its obligation to pay back the borrowed amount. This risk was highlighted particularly by the Lehman Brothers bankruptcy in September of 2008 which resulted in money market funds having to write off Lehman commercial paper.

This lead to all commercial paper, irrespective of issuer, selling off indiscriminately. Banks stopped lending to each other, cash markets froze and multiple counterparties, previously dependent on short-term funding, defaulted.

To manage counterparty risk, RE:CM only invests in counterparties with strong balance sheets – and analyses their prudential liquidity requirements, as required by the Reserve Bank, to identify banks that are facing potential liquidity pressure.

Instrument risk arises when the instrument does not perform as promised, due to adverse events in the market such as counterparty defaults or an increase in underlying credit risk. Money market instruments comprise a variety of instruments, including plain fixed deposits, tradable certificates of deposit, treasury bills, asset-backed securities and commercial paper.

These instruments have different risk characteristics, depending on the issuer and term. Treasury bills and bank deposits have the least risk due to security in the capital structure and the quality of the issuer. On the other hand, as demonstrated in the global financial crisis, commercial paper borrowers and asset-backed issuers have been known to fail.

When selecting money market instruments, it is important for managers to balance yield and risk and to know the nature of the underlying instruments. Managers could be lured into investing in high-yielding unsecured instruments where the yield does not compensate for the risk.

Liquidity risk

Liquidity risk arises when a money market fund experiences unexpected large cash outflows and has insufficient liquid assets to fund the outflows. An example of this was during the financial crisis when asset-backed securities and commercial paper were sold at a discount to face value as panicked investors redeemed en masse from money market and cash funds.

Selling illiquid instruments such as fixed deposits before maturity usually results in an additional cost, which reduces a fund’s income.